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    Chinese peg, policy and effects

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    China pegs the yuan to the US dollar at 8.3 yuan per dollar. Suppose that this is above the equilibrium level of the dollar in the foreign exchange market. What must the People's Bank of China do to maintain the peg? Next suppose the Chinese government abandons the peg and allows the yuan to float. With the help of a graph of the foreign exchange market from the Chinese perspective-where China is the home country so e has the dimensions of yuan/$-explain what will happen. What would be the effect on Chinese imports and exports?

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    Solution Preview

    First a fixed or pegged rate is the rate, which the government sets and maintains as the official rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

    A country might decide to use the pegging method in attempts to create a stable atmosphere for foreign investment. With a peg the investor will always know what his/her investment value is, and therefore does not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency. With a fixed currency, there is less speculative activity. Further, it should be noted that countries with pegs are usually associated with having unsophisticated capital markets and weak regulating ...

    Solution Summary

    What would be the effect on Chinese imports and exports?